This week, the New York Court of Appeals, the highest state court in New York, issued a decision recognizing that advice provided by underwriters on "market conditions" may give rise to a fiduciary duty.  The decision, joined by five of the six judges, imposes a common law overlay to the already highly-regulated securities industry and is likely to create additional uncertainty as to what duties and obligations underwriters and others in the industry have.

In EBC I, Inc. v. Goldman Sachs & Co., the Official Committee of Unsecured Creditors of the now defunct internet retailer eToys, Inc. brought suit against Goldman Sachs, the lead managing underwriter of the eToys IPO in 1999.  The eToys IPO, like most IPOs, was brought to the market through a firm commitment underwriting, whereby a syndicate of underwriters agreed to purchase the entire allotment of eToys shares to resell to the public.  As part of the underwriting contract between eToys and Goldman Sachs, eToys agreed to sell stock to Goldman Sachs for $18.65 per share and Goldman Sachs agreed to offer eToys stock to the public at an initial offering price of $20.00 per share so that Goldman Sachs' profit would be $1.35 per share or approximately 7% of the offering proceeds.  On the first day of trading on the market, eToys stock closed at $76.56 per share.  Just seven months later, eToys stock was trading at $25.00 per share.  Eventually, eToys filed for bankruptcy and a Creditors Committee was appointed.  The Creditors Committee brought suit claiming that Goldman Sachs had underpriced the eToys IPO because it allegedly had entered into secret side deals with preferred customers under which it allegedly was paid a portion of any profits that the customers made on aftermarket sales of eToys stock allocated to them by Goldman Sachs in the IPO.  The Creditors Committee claimed that Goldman Sachs' alleged side deals constituted an undisclosed conflict of interest and asserted numerous causes of action against Goldman Sachs, including a cause of action for breach of fiduciary duty. 

Though acknowledging that eToys and Goldman Sachs negotiated the terms of the underwriting contract at arms-length and that the contract itself did not create any fiduciary duty on the part of Goldman Sachs, the majority of the New York Court of Appeals held that Goldman Sachs could nonetheless be found, independent of the underwriting contract, to have owed a fiduciary duty to eToys in connection with the alleged expert advice that it provided on the pricing of the IPO:

[A] cause of action for breach of fiduciary duty may survive, for pleading purposes, where the complaining party sets forth allegations that, apart from the terms of the contract, the underwriter and issuer created a relationship of higher trust than would arise from the underwriting agreement alone.  Here, the complaint alleges an advisory relationship that was independent of the underwriting agreement. 

Specifically, plaintiff alleges eToys was induced to and did repose confidence in Goldman Sachs's knowledge and expertise to advise it as to a fair IPO price and engage in honest dealings with eToy's best interest in mind.  Essentially, according to the complaint, eToys hired Goldman Sachs to give it advice for the benefit of the company, and Goldman Sachs thereby had a fiduciary obligation to disclose any conflict of interest concerning the pricing of the IPO.  Goldman Sachs breached this duty by allegedly concealing from eToys its divided loyalty arising from its profit-sharing arrangements with clients.

This majority opinion arguably represents a significant departure from prior case law in which New York courts have been loathe to recognize fiduciary duties in arms-length transactions between sophisticated parties.  Indeed, in dissent, Judge Read remarked that "this new fiduciary obligation wars against our precedent."  She observed that the "eToys' prospectus acknowledged that the initial public offering price for the common stock has been negotiated among eToys and the representatives of the underwriters" and criticized the majority for "disregard[ing] that eToys was a sophisticated, well-counseled business entity."  The majority nonetheless held that a fiduciary duty could be found to exist if, as alleged, it was agreed that Goldman Sachs' profit in the IPO would be fixed at 7% of the offering proceeds and eToys "believed its interests and those of Goldman Sachs were aligned" because "the higher the price, the higher Goldman Sachs's 7% profit."  In dissent, Judge Read questioned how a fiduciary duty regarding the pricing of any IPO could ever be found between an issuer/seller and underwriter/buyer in a firm commitment underwriting: "How may a buyer ever owe a duty of the highest trust and confidence to a seller regarding a negotiated purchase price?  The interests of a buyer and seller are inevitably not the same.  Indeed, it is a longstanding principle of contract law that a buyer may make a binding contract to buy something that it knows its seller undervalues."

Though the majority noted that the fiduciary duty it was recognizing was "limited" on the facts to "requiring disclosure of Goldman Sachs's compensation arrangements with its customers," the majority opinion also contains language that arguably suggests common law fiduciary duties could be implied by courts in other circumstances: "to the extent that underwriters function, among other things, as expert advisors to their clients on market conditions, a fiduciary duty may exist."  As underwriters may be seen to be in the business of providing advice on "market conditions," the majority decision is likely to create additional uncertainty as to what duties and obligations underwriters and others have in the already highly-regulated securities industry.  As Judge Read noted: "The excesses of the market in the days of the internet high-tech mania did not go unnoticed by regulators. . . . How our new fiduciary duty for underwriters may fit into or conflict with the developing regulatory scheme is impossible to predict.  We have, however, at the very least introduced uncertainty into a complex subject."

The majority opinion of the New York Court of Appeals in EBC I compounds an already complex regulatory environment with additional concerns about what fiduciary duties might be found to exist under common law.  In light of the majority's recognition in EBC I of a fiduciary duty in an arms-length transaction, we recommend that underwriters and others in the securities industry include, where appropriate, express disclaimers of fiduciary relationships in underwriting agreements, engagement letters and other business agreements.

The majority and dissenting opinions in EBC I, Inc. v. Goldman Sachs & Co. are available online at http://www.courts.state.ny.us/ctapps/decisions/jun05/61opn05.pdf.

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Jonathan C. Dickey - Bay Area Offices (650/849-5324; jdickey@gibsondunn.com)
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